The summit between Brazil, Russia, India and China (the BRICs) in the Siberian city of Yekaterinberg Tuesday marked the first such official meeting of a group largely confined until now to the pages of economic analysis and sideline meetings at G20 gatherings. Signals from BRIC members suggesting they want to reduce their dollar assets and increase the use of domestic currencies in international trade have attracted much media attention and added to pressure on the dollar. However, the inaugural summit focused primarily on forging common positions on financial regulatory reform and climate change rather than foreign exchange rate management. However, this meeting, as with the meeting of the Shanghai Cooperation Organization on June 15 also in Russia, remains more political than economic. While the contribution of these economies to global growth is set to increase over the next decade, their different interests suggest that forging common positions may be difficult.
BRICs equity markets have surged in the global flight from safe assets and increased liquidity. The relatively more optimistic growth expectations for (most of) these countries has analysts speaking again of the ‘Decoupling Theory’. In particular, India and China are expected to be among a very few countries that will grow at or above 5% this year, contributing the bulk of global growth even as most of the advanced economies remain far in recessionary territory. The strong inflow of foreign investment into local markets has already triggered central banks to intervene and start to build international reserves once more.
While policy responses of these countries have been relatively robust, and they may outperform once a global growth recovery begins, they may be unable to decouple for long. In particular, with the outlook for domestic demand varying widely across these countries, each may again feel vulnerable to external pressures despite fiscal and monetary stimulus. Chinese domestic demand, suppressed for much of the past decade, does seem to be showing signs of growth from a weak base, encouraged by government incentives. However there is a risk that government stimulus might be prompting asset bubbles not a real increase in domestic final demand. Domestic demand in India and Brazil shows signs of resilience. Russia, though, is likely to experience a growth contraction of over 5% as domestic consumption and construction suffer. So, will the BRICs domestic demand hold up and can it fill the gap from a reduction in demand among the G3 (especially the U.S.)?
The belief that these economies will resume their promising long-term growth stories and recover from the current global crisis earlier than the developed world has fueled the significant outperformance of Emerging Market equities vis-à-vis their advanced economy peers. Liquidity stemming from quantitative easing and zero interest rates of most advanced economy central banks also added steam. At the start of June, the FTSE Emerging Market index rose 41.1% YTD and 60.8% since the beginning of March. (In contract, the FTSE All World developed markets index rose only 7.2% since the beginning of the year and 31.4% since the beginning of March). However, should global growth disappoint and risk aversion return, Emerging Market equities and commodities could be at risk of a correction, especially those that have had the largest rallies, such as Russia.
Despite their commonalities (mainly a desire for greater recognition of their weight in the global economy), there are significant differences between the BRICs in terms of their growth outlook, the channels through which they were affected by the global recession and their future growth possibilities. In particular, India and China are net commodity importers while Russia and, to a lesser extent, Brazil depend on commodity exports. Today we survey the ways in which these economies were buffeted by the financial crisis and global recession and assess their ability to make the structural reforms needed to foster long-term growth.
Brazilian Outlook Improving… For Now
The Brazilian economy has certainly felt the pinch of the global economic crisis as demand for its exports remains significantly lower, investments contracted sharply due to a much tighter credit environment, and business and consumer confidence were damaged. Moreover, Brazilian corporations had significant dollar liabilities, leaving them vulnerable to the fall in the Brazilian real.
Nonetheless, the overall performance of the economy has been somewhat resilient – Q1 2009 GDP was not as dire as consensus feared. The improvement in Brazil’s consumption in Q1 2009, especially on a quarter-on-quarter basis underpins the idea that there is some resilience in the dynamics of consumption in Brazil. Furthermore, Brazil might benefit from China’s commodity demand, meaning that the outlook for Chinese growth and the composition of its exports may be of even more significance to Brazil than that of the overall global economy. In fact, China surpassed the U.S. as the largest recipient of Brazilian exports earlier in 2009 . However, Chinese commodity imports could still be pricked by higher prices.
The Brazilian economy has experienced a strong pick-up in foreign exchange flows via both portfolio and direct investments in Q2 2009 and had a better-than-expected performance of the current account. The Brazilian central bank has put in place a considerably responsive monetary policy and monetary easing will likely add steam to the recovery. The central bank is also back accumulating international reserves.
In the longer-term, the Brazilian economy will only return to sustained growth if reforms contribute to productivity gains. Such a framework would require a more efficient tax system, increased trade liberalization, wiser government investments and a more efficient set of labor laws, among other things. Overall, Brazil now depends on credible macroeconomic policy-making where stability of prices and a sound banking system. The expansion of the middle-class and strength of the nascent housing sector require large investments in infrastructure and education, and adequate micro- planning. The expansion of potential growth will only take place if this appropriate framework is built. The abundance of natural resources may contribute to terms of trade gains; however these could limit the development of Brazil’s non-energy sector. Despite Chinese loans to Petrobras, the company still has significant investment needs to exploit the recently discovered and expensive deep-sea oil.
India: Slow Reforms Constrain Potential Growth
Capital inflows and the IT boom played a large role in driving job creation, investment and asset bubbles in recent years. India’s high dependence on foreign capital, mainly Foreign Institutional Investors (FIIs) and borrowing by companies, and IT exports increased its vulnerability to the global crisis. As a result, GDP growth in 2009 might fall to around 5% from the buoyant 8%-9% of rec
ent years. Yet, fiscal, monetary and credit measures are helping sustain growth. And a large consumption base, especially in rural and semi-urban areas, has sustained demand and corporate sales. Strong consumer demand and private sector investment plus a large share of government spending in GDP will certainly help fuel recovery. Yet a sluggish global recovery and lower credit growth would constrain the ability of private sector spending to drive growth, leading to a U-shaped recovery.
The absence of benign global conditions might make a 9% GDP growth rate tough to achieve in the coming years. But returning to above-potential growth may not even be sustainable and will only accentuate inflationary pressures given supply-side constraints. Increasing the potential growth rate from the current level will therefore require raising infrastructure and energy investments, agriculture yields, government savings, education spending, and implementing labor law reforms. But most of these reforms are politically challenging and will happen at a snail’s pace in the coming years.
The large fiscal deficit (over 10% of GDP during 2008-09) could stifle recovery in the next few years. Rising government borrowings could crowd out investment and invoke further rating downgrades. But overcoming structural deficits requires politically unviable measures like reducing farm and fuel subsidies. Instead, the government might focus on expanding domestic production capacities and acquiring energy stakes abroad.
But reforms can help strengthen domestic demand and tie it to domestic instead of external drivers. As the West de-leverages, India’s large population can be a potential source of new global demand. To do so, low-income groups need to be pulled up by job creation and higher incomes especially in the manufacturing and IT sectors. Rural development is also essential as the government still struggles to bolster industrialization and the private sector role.
A large population and rising incomes will offer immense opportunities for domestic and foreign investors ahead. As the recent Indian market rally shows, FII inflows, which declined in 2008, will again be bullish for India when the global recovery begins. While FDI has slowed in the recent months, liberalization and reducing red tape will help India attract more direct investment, reducing dependence on hot money inflows. The current crisis will only strengthen India’s sequenced liberalization policy whether in the financial sector or the capital account. But accelerating financial sector development would improve the intermediation of India’s large domestic savings and help reduce its corporates’ dependence on external capital.
India’s IT sector may find it difficult to maintain its outsourcing competitiveness as cost differentials with the West have waned since the last recession, other low-cost locations have emerged and the U.S. plans to raise taxes on outsourcing companies. To keep up, the sector needs to move to higher-end services and also expand the domestic client base.
China: Elusive Domestic Demand
The fall in external demand, as first the U.S. and then the EU and commodity exporters reduced demand for Chinese products, especially processed goods. Policies designed to slow the Chinese economy from its overheated 2007 state, particularly reigning in the domestic property market and the reduction of bank lending, ultimately exacerbated this slowdown. However, the Chinese government launched one of the most aggressive policy responses to the crisis, rolling out fiscal and monetary easing beginning in the fall of 2008, which has helped the economy accelerate from the near stall at the turn of the year. The Purchasing Managers Index (PMI) reflects that the Chinese manufacturing sector was the first to resume expanding, the property market is stabilizing on price cuts and ample domestic liquidity and retail sales are increasing. However, inventory restocking has almost been completed, meaning that China could find it difficult to return to the 10% growth of recent years should external demand remain sluggish.
So how effective is the stimulus? The most recent economic data continue to depict a mixed picture. The Chinese government has increased investment which grew at almost a 40% rate year on year in May 2009, pumped up by property sales. On the other hand, exports continue to contract, a trend that will likely continue through this year. Private sector investment also remains weak, pulled down by corporate finance issues and low profits. Moreover some of the policies may present costs in the future. The extension of credit poses the risk of inflating asset bubbles and might increase the number of non-performing loans in the future.
The real question: Can China pump up domestic demand soon enough in the tough external climate? Chinese private consumption’s share of GDP fell steadily over the last decade to around 35% meaning that it may have a long way to go to pick up the slack of the export sector and export-oriented investment. The relative performance of retail sales and auto sales illustrates both the ability of the government to influence public and private consumption and raises the possibility that China may have had a stronger underlying domestic demand dynamic than many credited. Yet, the weakness of imports, despite price-induced commodity demand, suggests domestic demand remains weak so far. In fact, both Chinese economic and commodity demand growth might take significant time to return to the 2007 and early 2008 trend. A more domestic driven growth might mean a slower pace than the 10% experienced in 2003-2007 with 8% being a more likely long-term growth trajectory. But such growth might not be beset with the sort of overheating experienced in 2007 and 2008.
Even as China has taken some steps to support domestic demand, it is clearly trying to support exports as well. China recently increased export rebates, for the seventh time in less than a year. The increase in these rebates boosts the disincentives to sell to the domestic market and with global exports weak, might be of limited use in supporting the economy. China has been relatively effective now and in the past at ramping up government investment, encouraging SOEs to spend and banks to lend. Yet, there is a risk that increased investment could contribute to domestic (and global) overcapacities which could create deflationary pressures. Should China be unable to absorb this new capacity (ranging from goods, to refined fuels to processed metals) at home, it might seek to increase exports, increasing a global supply glut. Moreover wider fiscal deficits will restrain spending later in 2010.
For a significant improvement in consumptio
n, a shift in government spending away from export-oriented manufacturing and expanding capacity is needed. In particular, increased government spending to bolster and extend the limited social safety net is required. Social programs account for well less than 10% of the planned fiscal stimulus, doing little to offset all of the structural incentives to save (including the need for self-insurance in healthcare and education and reliance on individual or family funds in retirement. Extending the unemployment scheme for one could have long-term positive effects on consumption, perhaps more so than the current approach of providing discounts and vouchers to encourage spending. Over time, this will also mean a stronger renminbi, given China’s likely stronger growth and productivity gains. Recent research from the Peterson Institute suggests that the renminbi would need to rise about 20% on trade-weighted basis to come into balance.
Unlike the other three countries, foreign investment in the domestic equity market is limited in China, keeping it less affected by foreign portfolio inflows than its counterparts. The development of a more significant domestic institutional investor base could be crucial to reducing vulnerabilities to foreign investment flows and might temper the speculative nature of the domestic equity markets. Diversification of corporate funding sources, through the development of corporate bonds and development of new exchanges could support the private sector contribution to growth, especially among small and medium-sized enterprises.
Russia: Still an Oil Story
Russia, this week’s host, often seems like the odd man out in the BRIC group and it seems particularly so this year. The fall in oil production and revenue along with the whiplash of the capital outflows on its heavy-borrowing banks and corporations will lead Russia to a severe economic contraction in 2009. Despite the more than doubling of crude oil prices since mid-March, Russia will have a difficult 2009 as financial sector vulnerabilities persist, construction remains weak, job losses rise and real incomes fall.
However, the increase in revenues does suggest Russia’s sovereign funds will end the year in stronger territory than expected given that the fiscal deficit may be narrower. This will leave Russia with further funds to use in 2010 when there is a risk of a weaker global recovery.
Once again, Russia faces the challenge of managing hot money inflows which have surged into the domestic equity market which has outperformed other emerging markets. As a result, the central bank is now intervening to keep the ruble from climbing too fast.
In the longer-term Russia faces several structural vulnerabilities that may restrain growth, weak productivity, it has under-invested in infrastructure relative to other emerging markets and its demographics do not support long-term growth. Moreover the subsoil law and uncertainty about the role of the state in the A sustained high oil price might actually create challenges for Russia as it would allow it to keep deferring the major structural changes to its non-hydrocarbon sector, especially manufacturing. Russia has now absorbed the lingering overcapacities in the natural gas and manufacturing sector from Soviet times, and further funds will be needed for growth. International oil and gas companies may be wary of increasing investment in Russia given the uncertainty about the role of the state in the resource sector, which has accounted for the bulk of FDI.
Despite some recapitalization of the banking sector, lending remains subdued, meaning that sectors like construction that drove domestic and total demand are likely to be weaker for some time to come. Falling real wages will weigh on consumption in 2009 even as manufacturing continues to show signs of contraction. However, if Russia is able to restart the investment program and make needed productivity gains, it could lead to a more sustainable growth dynamic for the non-resource sector and domestic demand.
Seeking a Global Role
All of these countries seek positions in international institutions more reflective of their weight within the global economy. India and Brazil have vied for a greater role in the UN Security Council (China and Russia are already permanent members and are veto players concerning North Korea and Iran).
The BRICs are expected to seek a common platform for advanced economies to commit to deeper carbon emissions cuts than is currently pledged. India and Brazil have been reluctant to join the global climate change regime that will replace the Kyoto Protocol. India’s climate policy stance has been criticized as it has abstained from signing the global emission reduction norms. While China has taken unilateral action to encourage the turnover of its auto fleet and reduce polluting heavy industries, it is reluctant to take steps that might limit its potential growth.
India has also persistently delayed the Doha trade talks (together with Brazil) to protect its farmers even as the country scores high on the list of imposing import tariffs and anti-dumping duties. Now that Russia has announced its plans to join the WTO only as a block with Kazakhstan and Belarus, its entry into the organization seems even farther in the future.
It is in global financial institutions like the IMF that the BRICs have most sought to increase their influence. The BRICs contribution to the IMF’s planned bond issuance (up to $50 billion by China, and about $10 billion each by the other three) could be a bargaining chip towards a more significant role in the institution even as it helps meet financing needs. Furthermore, it could help these countries diversify their reserve holdings. While India already has a low dollar share in its foreign exchange reserves, Russia, China and Brazil are trying to reduce their exposure. Russia has already been reducing its dollar share with the Euro having overtaken the dollar at the end of 2008.
The leaders of China, Brazil and Russia have been very vocal about the vulnerabilities of over-reliance on the US dollar as a reserve currency, seeking to increase the use of domestic currencies in trade. Yet there remain obstacles as noted by RGE monitor recently to more international or regional uses of these currencies, in particular the lack of convertibility, suggesting that changes are in the long-term It also remains to be seen whether these countries are willing to bear the costs of a more flexible domestic currency and recent reserve accumulation suggests they may be buying more dollars again.
As noted by Nouriel Roubini, China has taken
significant steps to increase the use of RMB beyond its borders; extending currency swaps in local currency with several emerging market economies, and considering the use of RMB in trade. At the same time, allowing companies to hold on to more of their foreign exchange and to use it to fund overseas operations could eventually imply a reduction in the management of the exchange rate. With China’s exports under pressure (the 26.4% y/y decline in May was the worst since data being collected in 1995), an appreciation of the RMB seems to be an issue for the future. Yet, despite the renewed verbal support from the BRICs for U.S. treasury bonds, the U.S. may have to pay more to meet its financing needs this year, as higher yields already indicate.